10 Effects of Inflation You Need to Know About

The Federal Reserve expects to raise its benchmark interest rate either this December or in 2018.

During September's meeting, the Federal Open Market Committee members discussed the low and unsteady rate of inflation, which persists despite continued low interest rates. The Federal Reserve aims for a 2% rate of annual inflation, a number which lightly encourages spending and investment while also giving the economy a buffer against deflation. Inflation has stayed below this rate every year since the Great Recession, and will likely do so again in 2017. Nevertheless, meeting notes indicate they felt that continued strength in other economic indicators, including the consumer price index, might merit an increase.

In part, this is because FOMC members, including Chairwoman Janet Yellen, are concerned that the economy could begin an inflationary cycle at any time. Once begun, it can take months or even years to slow down rates of inflation, so the Fed prefers to forestall the issue whenever it can. As a result it changes interest rates less in response to current conditions than in response to what it believes those conditions mean for future growth and inflation rates.

Several market watchers have suggested that the Fed would be premature to raise rates in the face of a job market which still hasn't fully shared in the economic recovery. However if a cycle of inflation does begin, here are ten major effects it will tend to have.

10. It reduces purchasing power

Inflation is defined as the erosion in purchasing power per unit of currency. In layman's terms, this means that each dollar can buy fewer goods and services than it could before.

This in and of itself sparks a cascade of effects through the economy. Despite a dominant narrative of inflation as an unmitigated ill for the economy, it isn't exactly true. In fact, inflation has a variety of effects, the impact of which can vary from person to person.

One of the few universally shared experiences, however, is tautological. During an inflationary cycle the same amount of money buys less than it did before. This pushes prices up, as sellers try to capture the same amount of economic value for their goods. Individuals either have to make more money per person or risk an erosion in their standard of living.

9. It incentivizes spending and deters saving

As inflation erodes the value of money one of the hardest hit sectors is pools of standing capital. Savings, particularly those kept in cash, lose value each year at the rate of inflation. A hypothetical $100 bill kept in someone's sock drawer would, at a 3% rate of inflation, have only $97 in purchasing power the following year.

This can, according to many economists actually benefit the economy at large. Inflation punishes savers and encourages spending and investment, pushing people away from hoarding cash and into more productive uses of their capital. Even a savings account at a bank typically will have interest rates that reflect the inflation rate to some degree, as that money goes to productive use. Lightly encouraging consumers to spend is, too, a good thing for the economy overall.

However it's important not to overstate this effect. At too high a rate this can cause a cascade effect. People can begin to pull cash out of even banks and investments and grow over-eager to turn it into tangible objects that hold their worth. Under these conditions long term savings and investment can suffer.

8. It helps debtors and harms lenders

Classically, inflation works in favor of people who borrow money. If someone takes a year to pay back a $100 loan, at a 3% rate of inflation she'll only need $97 worth of purchasing power. The lender will get back functionally less than he started with, even after receiving the same dollar amount.

Of course, that's a hypothetical situation. Today most professional lending institutions account for inflation in their interest rates. Whether fixed or variable, lenders expect a certain erosion of the dollar over the lifetime of the loan. Some inflation is certainly better for a debtor than none, but in practical terms the effect is minor.

7. It helps and hurts groups depending on income

Inflation affects people differently depending on how they earn their living. Investment-based income, for example, tends to flourish during cycles of inflation, as market returns are often one of the first sectors that reflect escalating prices.

For anyone who earns a salary or who lives on a fixed income, such as the principal of a retirement account or a pension, inflation hurts. The person's annual income stays the same while its purchasing power steadily vanishes. Third party forces might intervene, the salaried worker might get a raise for example, but absent that they're in the same position as the lender above. They get the same number of dollars each year and can purchase less with it.

Yet salaried workers who can bargain their wages up might gain considerably. For workers with good bargaining power (increasingly rare in the United States) inflation can actually cause real incomes to rise faster than debts and existing obligations. This can help substantially, but again at the cost of those on fixed incomes and workers who can't bargain as effectively.

6. It can hurt foreign investment

Inflation can chill foreign investment.

The relationship between inflation and foreign direct investment (FDI) remains difficult. Some economists dispute that it has any impact at all. They argue that exchange rates, resources and market opportunities define FDI, with little (if any) correlation between dollars invested and inflation.

Others argue that the effect is significant. In one study from India, a team of analysts found a correlation between inflation and FDI of -0.45%; in other words, sufficient inflation can reduce foreign investment by nearly half.

The economists who argue that inflation reduces foreign investment say that it's because inflationary cycles make an economy seem less reliable. Investors around the world lose faith that their money will be safe. Instead, they worry that they will buy into markets flush with increasingly devalued capital, low rates of interest return and an unstable currency. Moreover, they worry about the preservation of their own investment, and whether it will ultimately suffer from the same devaluation.

For example, if the euro held its value with no change, deflation in the U.S. would cause the dollar to lose value against it. The euro would be worth more dollars. This would have two immediate effects. With newly-valued money Europeans would be able to buy American goods more cheaply, thus boosting America's export market. Americans, on the other hand, would have to spend more dollars buying European goods than before, thus hurting the import market.

This would affect about $2.5 trillion worth of economic activity, but most Americans would feel it most directly on vacation. Travel to any part of the world would get just a little more expensive, while foreign visitors to America's shores would show up to spend a bit more money.

4. It creates its own feedback loop

Inflation doesn't hurt everyone. Hotels in popular destinations, for example, would probably benefit from a round of inflation, as would any export-based industry. Lenders don't like it, and America's vast array of imported goods would get more expensive, but student debtors might get a tiny bit of relief and those few workers left with great union representatives might pay off their mortgages early.

Prices rise, which isn't healthy for an economy overall, but it isn't an unmitigated evil either. So why do so many economists fear it so much?

Because it can create a self-sustaining cycle.

Runaway inflation is the zombie apocalypse of economics. It's the financial White Walkers meet a Borg cube of CPA's. When inflation gets out of hand it can create its own momentum, driving people to dump cash as fast as they get it. In this environment prices spiral upward as consumers get more eager to shed their cash before it loses even more value. Eventually people start bringing wheelbarrows to buy loaves of bread. It has happened before, and not just a few times. Yugoslavia in 1994; Zimbabwe in 2008; Hungary in 1946; and, of course, who doesn't remember Germany in 1923? Hyperinflation is a feedback loop that builds on itself. It might not happen often, but neither is it all that rare.

This happens for many reasons, but we'll look specifically at two. First, interest rates tend to rise as banks and lenders adjust for the new value of the dollar. They build this erosion of value into their model, so if the dollar will be worth 2 percent less next year, they ask for 2 percent on top of their profit margin. When that inflation rate goes up, so does their math.

The Federal Reserve's mandate is to balance employment growth with low inflation. As inflation rises, the central bank will begin pushing up its benchmark interest rate in an effort to discourage lending by making it more expensive. (This, ideally, slows down the movement of money through America's economic system and restrains inflation.)

In both cases, interest rates go up.

2. It is correlated with higher wages and increased hiring

Inflation often emerges from what's called the wage/price spiral. In this phenomenon, a strong economy leads to lots of people who hold good, well-paying jobs. They then create a large consumer base with money to spend.

That spending creates high demand in the economy, which spurs employers to hire and ramp up production in response. Eventually, however, employers can't easily hire in a tight labor market. They have to raise wages to compete for scarce workers, increasing their costs which they pass along to the consumer market. That consumer market has already begun to heat up due to increased demand from people with money to spend.

As is often the case with inflation, to a certain extent this is a good thing. Moderate wage/price cycles reflect a booming economy and its absence is one of the enduring mysteries of the post-Recession U.S. economy. The key, and the job of the Fed, is making sure it doesn't go too far.

1. It can spur growth, particularly in a consumer-focused economy

Inflation has one more potentially positive result: it can increase consumer spending.

This isn't only because cycles of inflation deter savings, although that's true as well. As discussed earlier, inflation also tends to correlate with rising wages in an economy. Workers will have more money to spend because of the extra cash flowing through the economy, and they generally have reduced debt burdens because inflation erodes the principal on debts.

This can lead to increased consumer spending across the economy, encouraging growth.

It once again must be pointed out that this effect should not be overstated. Inflation can drive spending in a consumer economy, but it also increases prices potentially reducing the value of that spending. It can also erode the assets of employers and producers, potentially hurting their ability to employ people.

It is not a one-size-fits-all solution, but neither is it the unmitigated disaster that many people fear.